Student loan forgiveness = Big tax bill

Congratulations! You did it. It took four long years of studying and hard work, but the day has finally come and you have earned your degree. Sure, you had to take out some student loans along the way, but it’s no big deal — you’re a college graduate! You’ll be making plenty of money.

Except, it turns out that starting salary is a little lower than you expected. In fact, based on your salary, there is no way you’ll be able to make your student loan payments under the standard repayment plan. Don’t worry though, the government is here to help; you qualify for the income-based repayment plan. What does that mean exactly? Well, under the income-based repayment plan your monthly payment will typically be 10-15 percent of your discretionary income.

Amazing! Your monthly payment is way less under the income-based repayment plan than it would be under the standard plan. But wait — these smaller payments barely cover the interest that is accruing on the loan… will you be making these payments until you die? Of course not! Under the income-based repayment plan, your remaining debt will be forgiven after 25 years. What a relief.

At first glance, this scenario might seem idyllic. However, when the end of that 25th year finally comes, this hypothetical borrower may be in for a shocking surprise. That forgiven debt? It could be considered taxable income and result in a hefty tax bill.

According to the IRS, taxpayers must include forgiven or cancelled debts in their gross income calculation. In other words, forgiven or cancelled debt is taxable income. There are a few exceptions to this policy; for example, those student loan borrowers who have their debt forgiven in exchange for 10 years of qualifying public-service work are specifically exempted by federal statute. Because exemptions exist for one classification of student-loan borrowers and not others, it lends credence to the notion that silence regarding income-based repayment plan participants indicates Congress’s intent that these borrowers be taxed on the amount of debt forgiven after 25 years.

There have been a few proposals in Congress to tackle this issue, but none have gained traction. It’s unclear exactly how the situation will shake out because the soonest anyone will qualify for the 25 year forgiveness is in 2019. If the IRS does indeed expect debtors to pay taxes on the forgiven debt it could come as a shock for a large number of people and the amount in question could be quite substantial. So, for now, it seems the best course of action is to open a savings account and squirrel away as much as possible in anticipation of a potentially monstrous tax bill… that, and pray.